Buyouts Review

At the end of 2005 increasing valuations for European companies and high debt multiples led some in the market to forecast a tumble in buyout fortunes for 2006. But it didn’t happen. Instead, returns remained strong, European buyout houses embarked on a fundraising spree, valuations continued upwards and ever-larger companies became targets for private equity.

But not all the news was unreservedly positive and there was increased media and public scrutiny of the industry. With the higher profile private equity attracted, regulators started to take more interest. There were also rebuffs in the UK by the boards of some public companies targeted by buyout houses.

Overall, last year was a fantastic one for buyouts in Europe, 3i’s global head of buyouts Jonathan Russell says: “2006 was as good as it gets, with continued economic stability, helpful capital markets and a good exit environment. It meant we were able to raise a €5bn fund and make some very good returns, handing back cash to our investors.”

The positive response to 3i’s fundraising was an illustration of the bullish sentiment among institutional investors to private equity. The firm’s initial target for its mid-market Eurofund V was €3.5bn but by November 2006 it closed at €5bn to become Europe’s largest mid-market fund.

In July Permira announced first closing of its Permira IV fund at €10bn, expecting the final amount raised to be around €11bn, which made it Europe’s largest ever buyout fund. The closing came just three months after the information memorandum was issued in the US and marked a significant increase on the original target of €8.5bn. Cinven, meanwhile, raised €6.5bn in its fourth fund.

It was this kind of fundraising that helped push up buyout volumes across the continent in 2006. In the first three quarters of the year, according to Thomson Financial statistics, the value of European buyouts totalled €150bn – nearly 50% up on the same period in 2005.

Much of this increase was due not so much to higher numbers of transactions, but to increased valuations and the fact that buyout houses were able to target larger companies. For example, 2006 saw the €12bn acquisition of Danish telecoms company TDC, the €8.3bn purchase of Phillips semiconductor business and the deals to acquire Pages Jaunes and Brenntag, both worth around €3bn.

To a large degree, 2006 represented a continuation of trends in 2005, with high levels of debt liquidity leading to more equity fundraising and larger deals.

It was not just the larger funds in Europe that set records in their fundraising. For example, in July UK mid-market firm Gresham raised £340m for its fourth fund in just one month. “We were overwhelmed by the level of interest,” says Gresham chief executive Paul Marson-Smith.

Returns remained buoyant in 2006, thanks to a positive exit environment and the development of a thriving secondary market. An example of what could be achieved was Advent International’s sale of Germany’s Moller Group for €1.1bn to Doughty Hanson, after having bought it only 18 months earlier for €100m.

Ian Armitage, chief executive of HgCapital’s London office, highlights his firm’s sale of healthcare company Castlebeck at 9x money in four years: “Everyone’s feeling pretty good about 2006. On the other hand, all parties come to an end and we’re probably at a cyclical high on prices.”

He adds that the highly liquid debt markets have enabled many firms to recapitalise deals. “There’s been a shortening of the average life cycle of deals, with investors taking out money through recaps.”

Allied to all this activity was a rise in the profile of private equity and an appreciation that buyout houses could do positive things with the companies they acquired, says an executive at one of the larger houses: “That kind of recognition was not so evident two or three years ago.”

With financial buyers the only bidders at many auctions, private equity could show that it was up for the challenge of transforming the business prospects of companies, including some targets that were regarded as poor bets. “People have started to realise that it’s a good thing that there is this community of private equity buyers who are willing to take on these companies and improve them,” says one private equity director.

3i’s Russell agrees. He points to the success of private equity in creating new jobs. For example, 3i invested €100m in 2004 in French transport infrastructure company Keolis. In 2006 it sold the company having made four times its investment and boosted the employment dramatically. It was a similar story with SR Technics, a repair company in the aircraft industry that 3i acquired from Swissair when it was in receivership and sold in September 2006. “When we sold it we’d increased the number of jobs from 2,000 to 5, 500,” says Russell, adding that there are now hundreds of examples across Europe of this kind of transformation.

But not everyone was convinced of the merits of private equity’s stewardship. British trade union the GMB criticised Permira and CVC, two of the owners of the Automobile Association (AA) for their management of the company since it was acquired from Centrica in 2004. The union launched an attack on the buyout houses after a refinancing of the AA worth £1.85bn, accusing private equity directors of asset stripping and destroying the AA through “sheer greed”.

Then there was the growing hostility towards private equity in some sections of the UK stock market, with shareholders increasingly resentful at seeing companies taken private and then sold back to the market at much higher prices.

Permira was one of the houses most affected, having failed either by itself or in club deals to take private HMV, Kesa Electricals and De Vere. Other examples of failed take-privates included Apax with House of Fraser.

With this new suspicion among some public shareholders, plus the rising valuation in the UK stock market, take-privates were sometimes problematic in 2006. “The take-private market is maturing and it is not only private equity firms that have become more sophisticated but also shareholders, which has made it more challenging to do public-to-privates in the UK,” says one buyout house executive, who asked not to be named.

He adds that the return to market of the UK department store chain Debenhams was a case in point. The company was brought back to the stock market in 2006, less than three years after having been acquired by a consortium of CVC, Merrill Lynch Global Private Equity and Texas Pacific Group. The owners raised profitability at the company but also made huge profits for themselves by taking out £1.3bn in dividend payments before floating the company.

The executive says: “I’d argue that the Debenhams deal was an example of private equity creating rapid value in a company and then returning it to the market. Others would see it in a negative light, as the financial owners giving it back to the stock market after having extracted as much financial value for themselves as possible.”

Simon Henderson, managing director at buyout house and mezzanine provider European Capital, says: “Many shareholders in the UK are less willing to sell because they have deals like Debenhams at the back of their mind and so are cautious.”

He points to the success of retailer Marks & Spencer in fighting off a bid from magnate Philip Green. Shortly after this the retailer’s share price fell, but since then it has recovered and the business is widely regarded as having been successfully turned around.

One of the key concerns of some shareholders is that public companies sold to private equity have been undervalued. “A lot of shareholders are jealous of private equity and see it as buying cheap and selling back dear to the market,” says Ian Armitage of HgCapital.

But he stresses that despite the problems the public markets are still open to private equity. HgCapital took private UK psychometric testing company SHL Group in November for £100m and Swedish accountancy software company Visma for £380m in July.

HgCapital also did a couple of IPOs, says Armitage, but he acknowledges that generally the record of private equity on flotations in 2006 was “spotty”, with some businesses that lacked impressive growth prospects taken to market.

Dominic Ely, private equity director at Investec, says that despite the difficulties surrounding some take-privates in the UK, there is no systemic problem: “Yes, there have been some failures but there have also been some high-profile successes.”

Although take-privates may have suffered in the UK market, this was not necessarily true in other European territories. According to data from research group CMBOR, there was a slowdown in the UK market during the year compared with activity in the rest of Europe. Buyout transactions in Continental Europe in the first half of the year grew much more rapidly than in the UK, according to CMBOR. It put France as the biggest market, although this was largely due to the large size of just one deal, TDC. France was also ranked on top in the numbers of buyouts, followed by Germany.

But many in the industry point to the fact that the UK is now a mature private equity market, whereas historically Continental Europe has been less active and offered a less benign environment for deals. “You would expect that, over time, growth would be faster in the less developed markets of Continental Europe,” says one buyout house executive, adding that in some European markets one or two very large transactions can skew the figures.

HgCapital’s Armitage says his impression was that UK activity was fairly slack and that, if one looks at long-term trends, the UK market has been growing at single digit levels in the last five years. Continental Europe, and particularly France and Scandinavia, have been growing much faster at 10%-15% a year.

But despite these trends, there are still plenty of opportunities in the UK, according to 3i’s Jonathan Russell: “There may have been a slowdown relative to the rest of Europe but the UK has still been pretty active. People talk about how competitive the UK market is but in some parts of Europe there is even more competition for some assets.”

While much of the increased competition is down to more funds being raised and continued high availability of debt, there has also been a return of trade buyers in some sectors. After largely bowing out of auctions in favour of financial buyers, trade buyers returned to sectors such as food and drink and cable TV in 2006. Paul Marson Smith of Gresham says he welcomes the return of trade buyers because their presence is a sign of a healthy market: “I’m always nervous when there are only private equity bidders for a company because I don’t believe these investments should just be a money-go-round in which companies change hands among financial buyers. We need to add value strategically to the companies we work with and invest for the benefit of all the stakeholders.”

When it came to the attitude of regulators, 2006 saw some interesting developments. At a European level an expert group of representatives from buyout houses reported to the European Commission on the role of private equity, the challenges it faced and what the regulatory obstacles were in Europe.

The group’s recommendations included calling for a common approach to private placements, to facilitate cross-border marketing of private equity funds. While some sceptics questioned whether the report would result in any change, others believed it was a useful exercise in highlighting the contribution of private equity to the European economy and pushing the agenda for private equity-friendly regulation.

In the UK the Financial Services Authority (FSA) looked into the industry, following its concerns about the large sums of equity being raised and high leverage levels. In November it published a discussion paper in which is said that, overall, it felt regulation was “effective and proportionate”. But it did flag up certain risks, such as the potential impact on lending banks in the event of a major default.

These concerns about high leverage levels are understandable, but perhaps the wider risks to the system of individual defaults are less today, given the evolution of the private equity market. Dominic Ely of Investec, points to the influx of new players and products in recent years, including hedge funds, specialist lenders and the large-scale syndication of loans. This has created a debt market that is broad and deep, he says, and means that any individual defaults are far less likely to affect the market than in the past. But he adds that if there are problems in the future, private equity houses may have to put more equity into deals.

According to Jonathan Russell, “The FSA report was a good piece of work and it showed that they understood private equity and what should and shouldn’t be regulated.”

The European association, the EVCA, also welcomed the FSA report and said it hoped other European regulators would work together and replicate the FSA’s pragmatism.

The shape of future regulation in Europe remains to be seen. What is clear, however, is that 2006 was the year that private equity really stamped its presence on the European economy. Bigger deals were done, increasing sums of institutional money poured into funds and competition for assets grew. All this generated increased interest in the industry from the public, media and regulators – interest that is only likely to grow in 2007.

What 2007 holds for the buyout market

Many in the buyout industry say they do not believe 2007 will surpass last year. This is because in 2006 a range of factors, including benign macro-economic conditions and highly liquid debt markets, came together to produce fertile ground for deals.

With the stellar returns of private equity in recent years there are now a lot more players in the market chasing deals and more uncertainty about the longer-term trend for interest rates and global economic stability.

As a result, opinions are divided about the prospects for the market in 2007. The great returns, high activity levels and bullish sentiment of 2006 could prove to be a high watermark, according to some. Others argue that the future still looks rosy, at least for those firms that can differentiate themselves in a crowded market.

At the more pessimistic end of the spectrum is Simon Henderson of European Capital.

“There’s been a considerable increase in the number of players, not just in equity but at every level of the capital structure and leverage levels are very high. It’s unsustainable.”

He predicts economic developments that will spark a reduction in leverage levels, whether that be rising interest rates or lower growth in demand for goods and services in China. Or it could be the high-profile failure of certain deals, which he argues are so finely tuned today that there is little margin for error. “Some companies only need to lose one important customer or see a competitor launch a price war and they’re at risk of default,” says Henderson.

The problem, he believes, is that this increasingly uncertain environment is evolving just at the end of a massive fundraising period: “There are all these funds that have raised huge amounts and the best thing they could do in today’s environment may be to sit on their hands, but that’s very difficult for them to do.”

As a result of the uncertainty, Henderson argues that it may be a better to be investing in mezzanine at the moment than equity: “We’re fortunate to have both an equity and mezzanine arm and I think that currently the risk-reward profile for mezzanine is better because if there are problems it will be equity that is hit first. On the other hand, a lot of mezzanine providers have been taking on more equity risk than they think.”

Another buyout executive, who asked not to be named, says: “Everyone knows we’re at a cyclical high in liquidity and leverage and I think the rise in prices and increased competition means 2007 will be a more difficult year. The question is whether any downturn is gentle or sudden.”

He adds that a key question in 2007 will be how big deals can go, given the increased firepower in many of the larger buyout houses’ funds.

According to John Gripton, a director at private equity asset managers Capital Dynamics, the fact that the market is at or near peak levels of debt availability does not presage problems for 2007. “Debt is still plentiful and we don’t see interest rates going up dramatically,” he says, adding that many deals have weak covenants, which means that even if there were a default the debt could be restructured.

He adds: “We feel fairly optimistic about the market and although there may be some concerns about the trend to acquiring increasingly large companies, these are smart managers who know how to source and action targets that large.”

Gripton says he anticipates a similar level of activity in 2007 to last year and that some managers will come back to the market early because they will have spent their funds in a shorter period than expected.

Another who is more in the optimists’ camp is Ian Armitage of HgCapital, who believes the market will continue to see significant growth because there is so much money now invested in private equity and the fact that the global economy is still in reasonable shape.

“These factors mean that people want to do deals,” he says. He adds that one of the factors driving the debt market and generating liquidity has been the participation of hedge funds: “One of the interesting questions in 2007 will be what the response of hedge funds will be if some of these companies run into problems.”

Jonathan Russell of 3i says: “It’s true that there’s a lot of money in private equity at the moment, but that’s true for all parts of the global economy, as there’s a great deal of capital seeking a good home.”

He adds that this environment will only be a problem for those firms that are not differentiated in the market. “If you just invest in something without having a strategy, but just because everyone else seems to be doing it, you’ll run into problems. Overall, it’s hard to see 2007 being as good as 2006 and I think it will be tougher, but as long as the global economy continues to perform well it should be pretty good.”